Long-Run Economic Growth: Productivity, Capital, Labor, and Living Standards

From Short-Run Fluctuations to Long-Run Growth

Short-run ups and downs change how busy the economy is relative to its capacity. Long-run economic growth is about something different: the economy’s capacity itself expanding over time. This matters for well-being because sustained growth is what makes it possible for average living standards to rise—more goods and services per person, better health technologies, safer infrastructure, and more leisure choices (even if not everyone benefits equally).

1) What “Growth” Means: Sustained Increases in Real Output per Person

In long-run growth, the key idea is real output per person (often called real GDP per capita). It focuses on how much the economy produces on average for each person, after removing the effect of price changes.

A simple way to organize the idea

You can think of output per person as coming from two building blocks:

• Output per worker (how productive workers are)
• Workers per person (how many people are working relative to the population)

In a compact form:

Real output per person ≈ (Real output per worker) × (Workers / Population)

This decomposition is practical because it separates two sources of higher living standards:

Continue in our app.

• Listen to the audio with the screen off.
• Earn a certificate upon completion.
• Over 5000 courses for you to explore!

Or continue reading below...

Download the app

• Raising productivity (more output per worker)
• Raising labor force participation or the share of people employed (more workers per person)

Practical step-by-step: diagnosing why living standards rose

1. Check productivity: Did output per worker rise? (Often driven by technology, skills, and capital.)
2. Check labor input per person: Did the share of the population working change (e.g., more women working, later retirement, fewer students working)?
3. Separate temporary from lasting: A one-time jump in productivity raises the level of output per person; sustained improvements raise the growth rate.

2) Productivity and Technology as Central Drivers

Productivity means how efficiently an economy turns inputs (labor, machines, skills, materials) into output. The most important long-run concept is labor productivity: output per worker (or per hour).

Why technology is so powerful

Technology is not just gadgets. It includes:

• Better production methods (automation, software, logistics)
• New products (medical treatments, communication tools)
• Improved organization (supply-chain management, quality control)
• Knowledge and ideas (designs, formulas, algorithms)

Technology matters because ideas can often be reused at low marginal cost: once discovered, a method can spread across firms and industries, raising productivity broadly.

Example: same workers, more output

If a factory introduces sensors and software that reduce machine downtime, the same number of workers can produce more units per day. Output per worker rises, and so can real output per person—without requiring more hours worked.

3) What Drives Productivity: Capital, Human Capital, Institutions, and Innovation

Physical capital: tools, machines, structures

Physical capital includes equipment, buildings, infrastructure, and technology embodied in machines. More or better capital can raise output per worker because workers have more (or higher-quality) tools.

A key practical idea is diminishing returns to capital: adding more machines helps, but each additional machine tends to add less extra output than the previous one if technology and skills don’t change.

Step-by-step example: capital deepening with diminishing returns

1. A small workshop buys its first modern machine: output jumps a lot.
2. It buys a second machine: output rises, but less than the first jump because workers, space, and coordination become constraints.
3. To keep gains large, the firm often needs complementary changes: better worker training, improved processes, or new technology.

Human capital: skills, education, health

Human capital is the productive capacity embedded in people: education, job skills, experience, and health. Human capital raises productivity directly (workers can do more complex tasks) and indirectly (workers can adopt and improve new technologies faster).

Practical implication: two countries with the same number of machines can have very different output per worker if one has better training, management skills, and health.

Institutions: the “rules of the game”

Institutions are the formal and informal rules shaping incentives and coordination—property rights, contract enforcement, predictable regulation, competition policy, and the ability to start and scale businesses.

Institutions matter for growth because they influence whether people and firms:

• Invest in capital (they expect to keep returns)
• Invest in skills (education pays off)
• Innovate (ideas can be commercialized)
• Allocate resources efficiently (productive firms expand, unproductive ones shrink)

Innovation: creating and diffusing new ideas

Innovation is the process of generating new ideas and turning them into usable products and methods. It includes research and development, experimentation, entrepreneurship, and diffusion (spreading best practices).

Innovation is central to long-run growth because it can keep shifting productivity upward even after capital accumulation faces diminishing returns.

Practical step-by-step: how an innovation becomes economy-wide growth

1. Discovery: A new method/product is developed (e.g., a more efficient battery).
2. Commercialization: Firms build processes and supply chains to produce it reliably.
3. Adoption: Other firms copy, license, or learn the method; workers gain experience.
4. Spillovers: Related industries improve (materials, software, logistics), raising productivity beyond the original sector.

4) Demographics and Labor Force Growth

Even if productivity is rising, living standards depend on how output is shared across the population. Demographics shape this through the size and composition of the labor force.

Key demographic channels

• Population growth: More people can mean a larger market and more workers, but it can also dilute capital if investment doesn’t keep up.
• Age structure: A higher share of working-age people can raise workers per person; an aging population can lower it.
• Labor force participation: Social norms, childcare availability, retirement rules, and health affect how many people work.
• Migration: Can increase the labor force and sometimes raise average skills, depending on who migrates and how well they integrate.

Practical example: two ways output per person can rise

Important nuance: increasing workers per person can boost output per person, but it may involve tradeoffs (less leisure, more caregiving burden, or policy changes). Productivity-led growth tends to raise living standards without requiring more hours worked.

5) Level Effects vs Growth-Rate Effects (With Simple Examples)

Long-run discussions often confuse two different impacts:

• Level effect: A one-time change that permanently raises (or lowers) the level of output per person, but does not permanently change the ongoing growth rate.
• Growth-rate effect: A change that raises the ongoing rate at which output per person grows year after year.

Example A: one-time productivity jump (level effect)

Suppose an economy adopts an existing technology (already invented elsewhere) that makes every worker 10% more productive, once.

• Year 0: output per worker = 100
• After adoption: output per worker = 110

If after that the economy goes back to its previous trend growth rate (say 2% per year), the path is permanently higher, but the slope is the same as before.

Before: 100 → 102 → 104.04 → 106.12 → ... (2% growth each year)  After:  110 → 112.2 → 114.44 → 116.73 → ... (still 2% growth each year)

Living standards are higher at every future date, but the long-run growth rate did not change.

Example B: sustained innovation (growth-rate effect)

Now suppose the economy changes in a way that increases the pace of innovation—better research networks, stronger competition, faster diffusion—so productivity grows at 3% per year instead of 2%.

• Year 0: output per worker = 100
• After 10 years at 2%: 100 × (1.02)¹⁰ ≈ 121.9
• After 10 years at 3%: 100 × (1.03)¹⁰ ≈ 134.4

The difference compounds. A 1 percentage point increase in the growth rate creates a much larger gap over decades than a one-time level jump of similar size.

How to tell which you’re looking at (step-by-step)

1. Ask if the change happens once or continues: A one-off reform or adoption is often a level effect; an ongoing improvement in innovation capacity can be a growth-rate effect.
2. Look for compounding: If the gap between two economies keeps widening over time, that suggests a growth-rate difference.
3. Check the mechanism: Capital accumulation alone often runs into diminishing returns (more level effect), while sustained idea generation and diffusion can keep growth going (growth-rate effect).

In practice, many real-world changes mix both: for example, improving education can raise the level of skills (level effect) and also make future innovation and adoption faster (growth-rate effect).